Rebalancing the world economy: Germany

The lives of others

The third article in our series on global rebalancing asks whether Germany can wean itself from its export dependence

THERE was a time not so long ago when European policymakers believed trade imbalances were only a problem for America and China. For much of 2008, a stock phrase in the press statement agreed each month by the European Central Bank's rate-setters was “the euro area does not suffer from major imbalances.” As the year wore on, the claim was repeated but seemed more and more desperate, as if it were a spell to ward off recession. It was only when the collapse of Lehman Brothers in September sparked a global slump that the formulation was quietly dropped.

In a narrow sense the claim was true. Until the crisis struck, the euro area's current account was roughly in balance. That contrasted with America, where a spending boom and falling savings drove the current-account deficit as high as 6% of GDP in 2006. But Europe looked steadier only because Germany's huge trade surplus offset deficits elsewhere—notably in Spain but also in France, Greece, Italy and Portugal.

These imbalances were not trifling. In 2007 Spain had the largest current-account deficit in the world outside America. The surplus chalked up by Germany that year, at $263 billion, was second only to China's hoard of $372 billion. Germany's saving glut allowed others to spend freely and to run up large debts. Its economy benefited from strong export sales to other euro-zone countries, as well as to America and Britain. The common currency allowed imbalances to grow unchecked by fears of an exchange-rate crisis.

But the skewed pattern of demand only made recession worse when it came. The biggest slumps in demand were in Spain and Ireland, where growth had been consumer-led. The impact on output was felt most in Germany, where a collapse in exports and investment drove GDP down by 7% from its peak. The question now, with its main customers pulling back, is whether Germany can kick its export addiction and encourage more demand at home.

A rebalancing of world demand requires high-savers, such as China and Germany, to spend more and run smaller trade surpluses so that the trade deficits of countries such as America and Spain can narrow as savings are rebuilt. Recession has forced that adjustment to begin in the most painful way. Germany's current-account surplus shrank dramatically, to 3.4% of GDP, in the three months to the end of March, from 6.6% of GDP during 2008 (see chart 1). The change in its external balance has made Germany the world economy's main shock absorber, says Hans-Werner Sinn of the Ifo Institute for Economic Research in Munich.

Much of the adjustment reflects a collapse in exports. Germany specialises in machinery and durable goods, purchases that businesses and consumers will put off when times are uncertain. It also reflects the resilience of domestic demand. German consumer spending has been broadly flat. That would count as a boom in many places where consumers are cutting back.

Fiscal policy has been a stabilising force, too. Germany's budget deficit should rise from around zero to 4% of GDP this year, and to 6% in 2010. Although it was a late convert to the need to do more, Germany's stimulus has worked well. Consumers have kept up their spending because most have held on to their jobs. A government scheme that allows firms to put underused employees on short-time working, and which subsidises their pay, has stopped unemployment rising sharply. Around 1.4m workers are on the short-time register, many of them in the depressed car and capital-goods industries. Cash incentives from government for older cars that are traded in for new ones have helped boost sales.

The short-time arrangements mean that workers stay in employment and keep their skills fresh. Firms are not panicked into laying off workers they might otherwise have to hire back again at great cost. “There is a certain accord with government to keep our core workforce intact for as long as possible,” says Matthias Wissmann of the German Association of the Automotive Industry (VDA).

The drawback of the short-time working scheme is that it prevents a broader economic restructuring. When Spain's fiscal-stimulus package provided funds to build low-cost housing, it was criticised for spurring more construction in a country that had already seen too much. Germany's schemes to prop up demand for cars and car workers have the same weakness. They fossilise an industrial structure that needs to change.

Officials see these initiatives as a “bridge” over global recession and they are candid about what they hope is on the other side: a return to export-led growth. Some point out that Germany's economy cannot quickly change its orientation towards domestic demand. It has a comparative advantage in producing specialist goods that require a global market. “You cannot put power plants in the supermarket,” notes one German economist. There is also widespread concern about the long-term costs of today's fiscal props for a rapidly ageing economy. Fingers are crossed that foreign demand will revive quickly so that Germany can get back to a balanced budget soon. Fine, except that it was Germany's export dependency and manufacturing bent that made its economy so vulnerable in the first place.

The presumption that what is good for exports is good for the economy partly explains why consumer spending in Germany has historically been weak. Its typical response to a faltering economy is to trim manufacturing costs, including wages, in order to keep exports keenly priced against other countries. That was the path taken in the early 1970s, when the D-mark rose after the collapse of the Bretton Woods system of fixed exchange rates. It was followed again after the 1990s when Germany's reunification boom and devaluations by some trading partners pushed up its relative wage costs.

The wage discipline was remarkable. German pay was more or less frozen for a decade from the mid-1990s, at a time when it was rising quickly in the rest of Europe. That wage restraint tilted demand in favour of exports and away from consumption. The share of employee pay in GDP drifted steadily downward until the eve of recession last year (see chart 2). So even as exports boomed and jobs were created, sluggish wages meant the gains from national income growth went mostly to profits. Consumer spending suffered, falling to a low of 56% of GDP—well below America's 70%. The increase in the rate of value-added tax (VAT), from 16% to 19%, at the start of 2007 was a further check on spending. It says something that the increase was sold as a way to boost competitiveness (VAT is a tax that hurts consumption but not exports).

This tale of export fetishism tells us how Germany looks abroad for demand to kick-start its recoveries and explains why its trade balance rises in the early phase of the cycle. But it cannot fully account for the vast and enduring current-account surpluses that Germany piled up year after year. They also reflect a persistent excess of domestic saving over domestic investment. The share of income that households put aside has been broadly stable for years but the investment share in GDP has declined (see chart 3). That is partly because Germany's mature export industries do not have great scope or appetite to expand capacity. It is also because capital is not finding its way to new ventures.

Some analysts believe that Germany's deep-rooted preference for equality in pay lies behind both its bent for export-led growth and the seemingly endless surpluses. In this view, a welfare policy designed to maintain a narrow gap between the best- and worst-paid employees has limited the earnings of the most skilled workers across all sectors, tempting many of them abroad. This “wage compression” has also stunted the emergence of a low-wage service sector that could cater to the home market. Wage floors prop up the pay of unskilled workers and make services expensive to supply. If personal services were on tap cheaply, consumers might spend more. Since investment in service industries is less attractive the pool of domestic savings leaks abroad.

Whenever firms are reluctant to invest, economists are quick to blame “inflexible” product and job markets. It is hard to start a business in Germany: it was ranked 102nd out of 181 countries on that criterion in the World Bank's 2009 Doing Business survey. Such regulatory barriers stop the economy's broader industrial structure from changing. Yet within manufacturing, businesses are flexible in their use of labour and in their control of costs. Germany's small capital-goods firms are famously nimble. If exporters were too rigid, they would not be quite so successful.

That suggests the standard wish-list of reforms might not make the economy any less dependent on exports and manufacturing. Germany's export addiction has deep roots. There is a wariness about services, particularly personal services, and a pride in being the world's biggest exporter. “Why does it take so long to start a company? Why are there so few links between universities and business? We have been wedded to the export model for so long we have ceased to look for alternatives,” says Thomas Mayer of Deutsche Bank.

Germany may never again run as large a current-account surplus as it did before the crisis, if only because many of its main export markets will not easily regain their former buoyancy. German makers of plant and machinery may feel they have a decent chance of bouncing back, thanks to China's state-sponsored recovery. Durable-goods manufacturers (especially carmakers) will find the going far tougher, as consumers in America, Britain and Spain struggle. If foreign demand does not fully return, jobs will go once short-time working schemes expire. The government will have to keep supporting the economy while the private sector restructures.

Cars for clunkers

A shift from export dependency to an economy that serves its own consumers better would be painful but would be good for Germany, and the world, in the longer run. Its big saving surpluses required big deficits somewhere else; the deeper Germany's customers fell into debt, the less their IOUs were worth. German banks ended up with toxic American assets because they had excess savings to recycle. When carmakers reached capacity limits at home, they used cash piles to make poor acquisitions abroad (Daimler and Chrysler; BMW and Rover).

“It made no sense for Germany to sell Porsches for Lehman certificates,” says Ifo's Mr Sinn. Those loaned funds could instead have been used to finance new ventures at home. Soon many Germans will reach retirement age; they will need a richer array of services than is on offer now. As some export industries shrink, new service industries will be needed to create jobs. That may even lift Germany's long-term growth rate. The export model left Germany at the mercy of changes in global demand. Yet there was no real growth dividend to compensate for that exposure. Growth in GDP per person in the past decade has been slower than in France and well below that in Britain or America.

There is a danger that Germany takes the wrong lesson from the crisis. It could decide the episode only shows the folly of relying on finance and services to drive growth, as America and Britain have. It could simply reinforce its long-standing export bias. But thoughtful Germans may conclude that a crisis that has created such a burden for future taxpayers stems partly from the ill use of their own savings. They may well end up wishing they had spent the money on themselves.